Sunday, July 15, 2018

Brace for China’s perfect storm

Brace for China’s perfect storm

Dark clouds loom over Shanghai’s financial district. Picture: AFP

Dark clouds loom over Shanghai’s financial district.
  • The Australian
  • 11:39AM July 2, 2018
There are few developed countries as closely linked to China as Australia. That’s why Australians need to understand why the Shanghai index fell more than 20 per cent before a minor 2 per cent recovery late last week.
Australians have always assumed that if the Chinese economy hits stormy waters then the strong administration in Beijing will pull all the required levers to cause the economy to resume its upward path. And so, in our local budget estimates, Treasury forecast a fall in China’s growth rate from the 6.8 per cent peak rate but assumed that growth would stay above 6 per cent in coming years.
That may well prove correct but the Chinese administration’s task this time around is made more complex because China is being hit with a perfect storm of forces which began to emerge well before US tariffs and other clamps were announced.
For many years the world has been concerned about the internal weaknesses in China’s banking system which has borrowed heavily and has a mountain of unrecognised bad debts and underperforming loans.
A year or two ago China began clamping credit and forcing banks to put on their balance sheet underperforming assets that had been concealed in off-balance sheet structures. And those disclosures brought to the surface major investments in international infrastructure that were not performing ——some of which had been undertaken under the smokescreen of the Belt and Road Initiative.
China put clamps on its shadow banking system and attempted to reduce corruption. Australia noticed a side effect via the increased difficulty Chinese investors encountered extracting money from China to settle off-the-plan apartments purchase contracts undertaken in Sydney and Melbourne some years earlier. But we benefited from the pollution reduction in steel making which increased demand for high quality Australian iron ore and coal.
But on that weakened China base came the Trump measures. China bravely announced its own counter measures and while key American companies have been adversely affected the blows have been felt more severely in China.
The nation has been promoting “Made in China 2025” and has been attempting all sorts of measures to gain US technology to achieve that goal including crude attempts to steal technology as I detailed last week. But when the rubber hit the road China found that too many of its corporations were currently dependent on US technology and components and as the share market began to appreciate the implications, the Shanghai index declined further.
Recently US observers have noticed that China is now talking a lot less about the “Made in China 2025” initiative and its ambitious future claims along with the technology stealing which had stirred the giant eagle. President Trump’s moves will force China to develop its own technology which will be a much slower process.
The editor in chief of the Chinese-government-run Science and Technology Daily, Liu Yadong shocked many in China when he addressed a seminar on China’s reliance on critical overseas technologies and abandoned the traditional inspiring Chinese rhetoric and told the truth.
Liu: “The house (China) is built on other people’s foundation, but some insist that we have complete and permanent property rights”.
Meanwhile the combination of the problems in China and the rise in the American currency caused a sharp fall in the Chinese currency, the renminbi. On the surface that meant that Chinese exports to the US were more competitive but in reality there were serious adverse implications for China. Suddenly the cost of imports, including oil, iron ore, components etc increased.
A number of large Chinese companies, sometimes to avoid the local squeeze and at other times to enjoy lower US interest rates, had borrowed in US dollars. That’s fine if your income is in US dollars but is a disaster if the US borrowing is funding ventures that have Chinese currency revenues.
The fall in the renminbi and the rise in the US dollar caused the currency of many of China’s South Asian neighbours to fall sharply and their companies had also borrowed in US dollars. The fall in these currencies was multiplied by the race to safety which has seen money pour into US dollars causing US bond rates to fall from their peaks set earlier this year.
When any share market falls 20 per cent it almost always has wide ramifications for a nation because it saps confidence and makes capital raising much more difficult, particularly for highly leveraged companies. Part of the reason why the fall in Shanghai has been greater than Hong Kong is that the Chinese have been punting their share market with borrowed money. It is estimated that $US 1 trillion has been borrowed on Chinese shares. It is likely that the forced sales have played a big role in the decline.
The Chinese regulators have responded by releasing credit to allow greater bank lending. If the Shanghai index responds with a sustained rally there will be sighs of relief all around. The Chinese authorities were encouraged by Friday’s rally and hope it will continue.

Chinese institutions will be encouraged to buy shares. If they fail to establish a sustained upswing and the market resumes its downward path then everyone needs to fasten their safety belts, including Australia.